EPA Unwavering in Support for Ethanol, Despite Drought

Last Friday the US Environmental Protection Agency (EPA) rejected the petitions of a bi-partisan group of state governors for a waiver of the federal ethanol mandate, resolving one of several energy-related issues that had been deferred beyond the presidential election.  The waiver requests filed in August cited the harm that the Renewable Fuel Standard (RFS) is causing to the poultry, dairy and livestock sectors and related businesses--and by extension to consumers--by increasing competition for corn during a severe drought that has sharply constrained supply.  The EPA's detailed response made frequent references to the "high statutory threshold of severe harm to the economy" required for a waiver of the RFS, and to the output of a model simulating the market for corn and ethanol. It also included the extraordinary assertion that, "the RFS volume requirements will have no impact on ethanol production volumes in the relevant time frame, and therefore will have no impact on corn, food, or fuel prices."  If that were true, then it's not obvious why the mandate should exist at all.

In rejecting pleas for relaxation of the ethanol standard, the EPA appears to be relying on two key facts.  First, wholesale ethanol prices remain lower than wholesale gasoline prices, despite corn prices that are high enough to force many ethanol producers to cut back output.  I'd attribute that mainly to weak US gasoline demand and the much-discussed impact of the "blend wall" in limiting ethanol to 10% of the gasoline pool, rather than as a sign of an unaffected market.  The agency is also relying on the availability of "paper ethanol" in the form of Renewable Identification Number (RIN) credits from past over-blending of ethanol by refiners and other gasoline blenders.  The EPA's estimate puts the number of available RINs at the equivalent of 2-3 billion gallons, or around 20% of this year's 13.2 billion gallon conventional ethanol requirement. As a result of these factors, EPA can claim with some justification that ethanol prices are not harming motorists at the gas pump at this time.  That's small consolation to the petitioners.

EPA's assurances to those in the poultry, dairy and livestock value chains are based on much thinner evidence--in fact, on none at all, unless you count as evidence a model that predicts corn prices would only fall by $0.58 per bushel if the ethanol mandate were eliminated entirely.  Simulations are useful but still aren't reality. The output of a model is only as good as its assumptions and algorithms, and when that output defies logic, it calls for the application of good judgment, particularly when the result happens to align so neatly with the internal concerns about the long-term implications of a waiver that are evident in the agency's response.  I can't help concluding that an agency whose management possessed greater depth and breadth of experience outside of government--especially in the business sector--would have given more weight to the struggles of the dairies, ranchers, meat-packers and others who are being squeezed by a mandate that is projected to consume 42% of this year's corn crop and is very likely inflating the cost of the Thanksgiving meal that many of my US readers will eat on Thursday.   This administration's lack of outside experience has been a glaring shortcoming that the President could easily remedy as turnover creates openings at the start of his second term. 

I can't say that I'm surprised by the EPA's ruling on the waiver requests.  I also can't help wondering whether it provides any indication of how the administration is likely to deal with the other issues that were deferred until after the election.  Yet even if we can't read anything else into this decision, it's clear that the Renewable Fuel Standard enacted in 2007--before the financial crisis and recession--is in serious need of reform.  If its language doesn't require the EPA to adjust the ethanol mandate in light of a drought that will result in the smallest corn crop since 2006, when US ethanol production was 65% lower than last year, then the law simply didn't incorporate sufficient foresight about possible future events.  Together with its unrealistically ambitious cellulosic biofuel standard, the provisions of the RFS increasingly seem to relate to some other, parallel universe, rather than the one in which we live.  

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Food vs. Fuel and the Midwest Drought

It was bound to happen.  As long as US corn output continued to climb year after year, the federal mandate to blend steadily increasing quantities of ethanol into gasoline could be accommodated without creating a shortage of this staple grain.  Unfortunately, crops are subject to all sorts of uncertainties, including the severe drought conditions that the middle of the country is experiencing this year.  Estimates for this year's corn crop have been revised downward, and corn prices have already broken through $8 per bushel, up from less than $6 a month ago, with consequences for the livestock, processed food and ethanol industries, as well as for export markets.  As soaring feed grain prices begin to translate into higher grocery prices for meat, poultry, dairy and other goods, will consumers demand relief from the EPA, which has the authority to curtail ethanol volumes?  The current betting appears to be that the administration will stand fast on the mandate, but anything can happen in an election year. 

Ethanol now accounts for at least 10% of US gasoline blending, by volume.  To meet that demand, ethanol producers will require around 5 billion bushels of corn.  In recent years, the ethanol industry's expanding corn demand was met by a combination of increasing yields and planting more acres in corn.  However, corn yields per acre are dropping sharply this year, potentially pushing output below last year's 12.4 billion bushels, if conditions don't improve soon.  That's in contrast to earlier expectations that this year's corn crop would exceed last year's by 20% .  This isn't the first time that the food vs. fuel trade-off inherent in crop-based biofuels has become an issue, but it might be the first time when both the demand for corn for ethanol is so high and the need for that ethanol in the gasoline blending pool is arguably so low.  In this context, food vs. fuel quickly boils down to a debate over the tangible benefits of corn-based ethanol as a fuel.  There's growing evidence that those benefits have been oversold, despite industry claims.

Start with the widely touted study from Iowa State University indicating that ethanol saved consumers $1.09 per gallon at the gas pump in 2011 and $0.89/gal. in 2010.  I read both the original study and its updated version when they came out.  It seemed obvious to me that the authors' grasp of gasoline markets and oil refining were inadequate, but I lacked the time necessary to dig through their math to uncover the source of their exaggerated results.  Fortunately, a pair of researchers from MIT and my alma mater, U.C. Davis, have now done that work and concluded that the Iowa State paper's findings--and the claims based on them--depended on a "spurious correlation": the relationships they saw were coincidental.

In contrast to the Iowa State studies, the MIT/Davis paper is very readable, and I recommend it to you.  In addition to debunking the statistics, the authors point out the key flaws in their counterparts' logic.  Foremost among these is that in order to have a large influence on gasoline prices, ethanol would have to have had a large impact on crude oil prices, which are the largest determinant of gas prices, by far.  From 2005-11 US ethanol production expanded by 10 billion gallons per year, the energy equivalent of 350,000 barrels per day of oil, or 0.4% of 2011 global oil supply. I've argued many times that the oil market responds disproportionately to modest changes in supply and demand, but the idea that a few hundred thousand barrels per day could translate into the equivalent of $45/bbl exceeds the wildest dreams of any trader I ever met.  The MIT paper concludes with the authors summarizing the likely impact of ethanol on gasoline prices as "near zero and statistically insignificant."

However, if ethanol hasn't done much to hold down gas prices, could a drop in US ethanol production resulting from paring back the ethanol mandate to reduce the pressure on corn prices cause a big spike in gasoline prices?  That's where the analysis in a paper presented to members of Congress yesterday comes in.  Dr. Elam's report suggests that rather than displacing imported crude oil, the main effect of increasing US ethanol use in fuels has been to divert domestic gasoline production into exports, while US crude imports have fallen based on a combination of lower demand (from the recession) and improved product yields per barrel of crude oil refined.  Even if you are inclined to be skeptical of these findings because the study was supported by poultry interests, data from the US Energy Information Agency and elsewhere show that US refineries are not fully utilizing their capacity, are exporting significant volumes of gasoline, and have a wider array of domestic and imported crude oils at their disposal than they did just a few years ago. In short, we're in a far better position to forgo a few billion gallons of ethanol this year than we would have been in 2008, the last time food vs. fuel concerns spiked along with gas prices. 

Corn growers have experienced droughts before, and in the past the price of corn sorted out who needed it most.  However, the market can't prioritize fairly among the competing calls on a drought-diminished corn crop when the single largest segment of demand is locked in place by a federal mandate. This represents a massive distortion that only the government can rectify. I'm sympathetic to the ethanol industry's dilemma.  After all, the federal government virtually begged them to overbuild capacity, but it couldn't guarantee they would earn a profit, even when it was providing a $0.45/gal. subsidy for their customers, who are required by law to use their main product.  However, the economic and environmental benefits of ethanol are too modest to shield this industry while forcing all other corn users to absorb the likely shortfall in corn supply.  The most sensible remedy would be to unshackle ethanol demand, at least temporarily, and waive at least a portion of the ethanol mandate for 2012-13.

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The "Water-Food-Energy Nexus"

A summary of annual risk forecasts in a Linked-In group led me to a very interesting presentation on global risks from the World Economic Forum, the body that puts on the annual movers-and-shakers shindig at Davos, Switzerland. Among the risks they highlighted are those associated with what they termed the "water-energy-food nexus". The food vs. fuel concerns I explored in Friday's posting make up just one subset of this much larger and more complex set of interactions. These can be further expanded--and complicated--by incorporating the relationships between this triad and climate change. Although the WEF identified a number of steps that could be taken to address this poorly-appreciated challenge, it requires a leap of faith to imagine we could tackle this issue as systematically as it seems to merit, in light of our track record on other big but comparatively simpler challenges such as energy security and the ongoing deficit and debt problems of the developed world.

The extra complexities resulting from adding water to the already thorny food-fuel relationship are nicely illustrated by a systems chart in the WEF's analysis. It shows food security, water security and energy security linked by a series of sometimes reciprocal inputs, and influenced by other factors such as population and energy growth and environmental pressures, along with two overarching risks of global governance failures and economic disparity. All of this leads toward geopolitical conflict. It's a sobering assessment, even without including the missing arrow flowing back from food security to energy security. Biofuel produced from food crops makes up an increasingly important source of global liquid fuel supplies, so the "food intensity of energy production" deserves inclusion with these other factors, too.

This isn't the first time that I've seen a diagram portraying these interactions. I can't help wondering whether the WEF viewpoint was influenced by some scenario work that I encountered through my involvement with Global Business Network in the 1990s and early 2000s. I was fascinated by Gerald Harris's description of the triangle connecting water, food and energy, which has become much more apparent in the years since I first saw it. Although at the time the traditional energy industry understood its relationship with water pretty well, the water intensity of corn ethanol wasn't yet an issue, because US ethanol production was under 2 billion gallons a year, less than a sixth of its current level. And while some oil and gas wells have been hydraulically fractured for decades, the mass application of this technique to unlocking shale gas resources was still in its early days and hadn't percolated into the public's consciousness. Yet while the use of (and impact on) water in energy has become a much higher profile issue, metrics for comparing the water intensity of energy produced from different sources are still evolving. And we've barely begun to think about how for example water, which requires energy to capture and distribute, is used in producing energy, affecting the availability of water for growing food, some of which is then turned into energy. You can start similarly convoluted chains with food or energy, too.

We've typically looked at issues such as those in the examples above in terms of simple, binary decisions, rather than complex tradeoffs calling for integrated resource planning among all affected parties, at both the regional and local level, and markets that account for as many of the real costs and relevant externalities as possible. Yet without taking anything away from the work of the groups that the WEF mentions are looking at these problems in Indochina, Jordan, and elsewhere, we simply don't have the kind of governance in place to do this globally. If the UN can't come to grips with climate change and nuclear proliferation, then the future of the "water-food-energy nexus" seems far likelier to play out either in isolation or as a series of one-off efforts among highly motivated (desperate?) parties. And with last year's favorite governance body, the G20, heading into what some are calling a "G-Zero" world, it's not clear who else could take up this mantle. In the absence of some improbably comprehensive global approach to managing these interdependencies, it's up to those working in the affected industries to ensure that these factors are at least reflected in the planning and analysis of major projects and investments.

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Food vs. Fuel, Redux

Today's Washington Post includes a noteworthy opinion piece from Tim Searchinger of Princeton University concerning the impact of expanding biofuel production on global food prices and availability. Food vs. fuel competition made headlines in 2007 and 2008 but then subsided during the recession and financial crisis. This year, with global crop yields down and food demand up, and with food-derived biofuel production at record levels, the issue has returned. The relationship between biofuel output and food prices is certainly complex, but it is significant, particularly for those who spend much of their incomes on unprocessed grains and vegetable oils. And both population and biofuels demand will continue to increase from today's levels.

You might recall Mr. Searchinger's name in conjunction with a high-profile scientific paper in 2008 casting doubt on the value of crop-based biofuels in reducing greenhouse gas emissions. "Global land use impact" entered the lexicon of environmental consequences as a result of his and his collaborators' work, and it had a significant influence on the EPA's updated Renewable Fuel Standard (RFS) regulation, even if the agency's final version of the rule softened its application in constraining the least efficient corn ethanol facilities. So you might say that Mr. Searchinger is no great friend of first-generation biofuels in general. However, the issue that he's writing about today, while no less controversial in energy and policy circles, is much more straightforward to understand than the carbon debt of newly cultivated cropland.

As he notes in his op-ed, numerous studies have demonstrated a link between biofuel production and food prices in 2007-8, even in the US, where the basic inputs subject to this kind of price competition constitute a small portion of the retail prices of the processed foods we eat. It affects US food price inflation, but mainly indirectly through routes such as raising the price of livestock feed. Among others, the Congressional Budget Office looked at this issue in 2009. Most of the studies I saw also showed a significant effect on food prices from rising energy prices, another phenomenon that has reappeared in the last year. However one interprets all this, it is inescapable that a bushel of corn turned into ethanol is not available for export to countries that are experiencing a combination of rising demand and disappointing harvests.

As long as US harvests were increasing at a rate that kept pace with the growth of ethanol output, thanks to increased cultivation and better yields, that wasn't a zero sum game. Until recently, the corn that went into making ethanol was corn that might not otherwise have been grown. But in a year like this one, when annual ethanol consumption is set to rise by another billion gallons while the corn harvest is 5% smaller than the previous year's, something has to give. In fact, the US Department of Agriculture expects that ethanol plants will take 40% of this season's crop, compared to just 23% in the 2007-8 "market year." That exerts a lot more pressure on corn prices, which are pushing $7 per bushel for the first time since 2008.

If anything, the conclusion of Mr. Searchinger's op-ed downplayed the risks ahead. With output from the nascent cellulosic ethanol industry still minuscule, the EPA will be under tremendous pressure to allow corn ethanol to continue to expand beyond its current 15 billion gallon per year limit under the RFS. That's one reason the industry was pushing so hard to increase the maximum allowable percentage of ethanol in gasoline from 10% to 15%; it needs that headroom to continue expanding output beyond last year's 13 billion gallons. At 20 billion gallons per year--a quantity that I heard one USDA expert suggest several years ago was achievable--ethanol would require the equivalent of 55% of 2009-10's record US corn crop. It's hard to envision that happening without concerns about food vs. fuel rising to a much higher pitch.

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Corn Nation

Driving across Ohio, Indiana, Illinois and Wisconsin, it's impossible not to be struck by the dominance of corn cultivation in this part of the Midwest. Those "amber waves of grain" in the song look more like amber waves of corn tassels, here. My family makes this drive every few years, and my unscientific impression is that we see more and larger corn fields every time. Given my focus on energy, I couldn't resist spending a few minutes using the hotel Wi-Fi to check on my hunch that most of this has been driven by the explosion of ethanol production in the last decade--up an average of 22% per year since 2000.

Based on data from the USDA, corn production has grown substantially in the last decade, though by a much smaller annual percentage than ethanol output, and with the peaks and valleys you'd expect for a crop affected by the variability of the weather. The total acres planted in corn have risen, though at an even slower rate, so that steady yield improvements have contributed as much as acreage to the growing corn supply. It might seem like an exaggeration to suggest that ethanol is the main factor behind all this growth, yet when you examine the trends in corn disposition, it would be hard to avoid that conclusion, as the chart below shows.




Since 2000, ethanol has gone from consuming about 10% of the annual corn crop to taking just over a third of a much larger crop. Over that same interval, the other main corn demand sectors have remained relatively constant. The modest drop in corn used for livestock feed probably correlates with the increased output of distillers dried grains byproduct from ethanol plants. For all the controversy about high-fructose corn syrup in our food and beverages, the quantity of corn involved in sweeteners hasn't changed much since the mid-'90s, and the US exports roughly as much corn annually today as it did before the current ethanol boom began. So it really does seem to come down to ethanol, and that has important implications for farmers and ethanol producers, because the practical limits of the expansion of corn ethanol are now in sight.

Corn ethanol output has doubled three times in the last decade, but it is most unlikely to double again. Even if the industry can convince the EPA to forestall the looming "blend wall" by raising the proportion of ethanol allowed in gasoline, ethanol's favored status under the federal Renewable Fuels Standard ends at 15 billion gallons per year of output, beyond which it will find it very hard to compete with biofuels from other mandated sources, including sugar cane and--whenever it becomes commercial--cellulosic ethanol. The impending debate over the extension of the current ethanol incentives signals big changes in the trends that have provided such a boost for US agriculture.

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Energy Lessons of 2008

A year ago, I looked back on 2007 and ahead to 2008, a year that has defied the predictions of most observers. Although I can't claim to have foreseen the possibility that oil would break $140 and $40--from opposite directions--in the same year, I worried about energy market volatility and cautioned that risk cuts both ways. That seems equally appropriate advice today, when markets are focused on the downside, and "confirmation bias" is such a powerful force. But while we shouldn't expect a repeat of the wild ride of the year now ending, the experience has provided some expensive lessons about energy markets. The following is a non-exhaustive list of those that struck me:

1. Demand matters as much as supply in determining prices. The difference between oil at $145 per barrel and $40 is only a couple of percent of global demand, or more precisely a swing between steady growth of 1-2% per year and a shrinkage of similar magnitude.


2. Speculation can amplify prices and market volatility, but it can't override a dramatic shift in the underlying fundamentals of supply or demand. Leverage increases not only the magnitude of speculative gains and losses, but apparently also the speed of the shift from one state to the other.


3. When prices have been rising steadily, commodity price hedging can look like a sustainable revenue source--almost a perpetual motion machine--until the trend breaks. Then we see that the main benefit of hedging is to smooth out cash flows and enable firms to take on risks they couldn't bear otherwise. Used improperly, it's just an elaborate form of speculation, and as risky at Las Vegas.


4. Fundamental price imbalances between commodities that are substitutes for each other, however imperfect, don't persist indefinitely. For much of the year, natural gas traded for less than half the energy-equivalent price of oil. As of Friday, this relationship had closed to about an 11% discount for gas vs. oil.


5. High oil prices don't automatically make alternative energy sources competitive. For the last several years many alternatives faced higher construction costs, as they competed for some of the same inputs (materials and workers) as new oil and gas projects, while alternatives with low "net energy" or Energy Return on Energy Invested (EROEI) saw their operating costs rise in tandem with oil and gas prices.


6. In particular, investors in corn ethanol production found they were making two bets: one on the difference in price between food and fuel and another on the difference between petroleum products, with which ethanol competes, and natural gas, of which it consumes large amounts, directly and indirectly. (See #4 above.)


7. Government incentives and mandates can help to create a market for alternative energy, but they cannot guarantee its profitability, particularly when capacity is added faster than mandated targets rise, or than existing infrastructure can accommodate. The recent Chapter 11 filings of VeraSun and several other ethanol producers are evidence of this.


8. The cost of capital turns out to be as important as the cost of oil for the expansion of all forms of energy, conventional and alternative alike.

I'm sure I've missed some important learnings in this quick tabulation. Next week I'll look at what the coming year might bring, or at least what bears watching. In the meantime, I wish my readers a happy, healthy, and more prosperous New Year. Let's hope the economic consensus is as wrong about the length and severity of the contraction we're in, as it was about the prospects for a soft landing from the bursting housing bubble.

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